Selling Short Puts vs. Covered Calls

by John Jagerson | July 7, 2009 8:18 am

This article is brought to you by LearningMarkets.com[1].

Selling or writing options[2] is one of the most effective strategies available to options traders.

Among the advantages is the fact that time value[3], over the length of the option’s life, melts away in your favor. This happens because the closer you get to expiration, the less time the option has to reach a profitable price, making it less valuable to buyers.

In this lesson, we will cover two option selling strategies — selling puts and covered calls — from a risk and reward perspective, and learn how they relate to other strategies you are already familiar with.

Did you know that selling a put has the same risk profile as a covered call[4]? That surprises most traders when they first begin to understand how this trade works.

In fact, over the long term, selling a put can be as effective as a covered call from a volatility perspective. Plus, it can reduce trading costs. This is because a short put only has one position (the put) rather than the two positions (the long stock and short call) involved in a covered call. (See Selling Puts vs. Covered Calls — Which is Better?[5])

Selling a put is essentially a bullish strategy. It’s bullish because you are the seller and are hoping to sell the put now for a high price, and then let it expire worthless or buy it back later for a lower price after the underlying stock has risen.

If stock prices rise, a put will decline in value and, ultimately, any put that expires out of the money is worthless. That is a great position to be in as the put seller, because you keep the premium, with no obligation to deliver any stock.

Let’s discuss these strategies by contrasting the two trades on a single stock.

The SPDR Gold Shares (GLD[6]) is an exchange-traded fund (ETF) that follows gold prices. As you can see in the chart below, GLD had been on a nice long-term uptrend, and in June 2008 was sitting at support at $85.59 per share.

If you had been bullish on gold at that time, you could have traded a covered call or sold a short put.

Covered call entry trades:

1. Bought 100 shares of GLD: $8,559

2. Sold one contract of 86 strike call, 30 days expiration: $250 premium

Short put entry trade:

1. Sold 85 strike put, 30 days expiration: Collected $230 premium

What happens if the stock rises to $90 by expiration?

Covered call exit trades:

1. Sell 100 shares of GLD at exercise for $8,600 (the strike price of the call)

2. Keep the $250 call premium

3. ROI: 3.3%

Short put exit:

1. Put expires worthless; you keep the $230 premium

2. ROI: 2.7% (assuming you left $8,500 in your account to cover losses)

Now, what if GLD falls to $80?

Covered call exit:

1. Keep the stock with a loss of $559

2. Keep the $250 call premium

3. Losses: $309

Short put exit:

1. Buy back the put at expiration for $500

2. Keep the original premium of $230

3. Losses: $270

If the put’s strike price is equidistant from the current price of the stock as the call’s strike price, the short put will lose a little less to the downside but has a smaller maximum gain on the upside. That is the situation we saw in the example. In the live market, the prices and situation will obviously vary.

The reason both trades have the same risk is because the exposure to the downside is the same. As the stock falls in value, a covered call trader will lose on the stock. Similarly, as the stock falls in value, a put seller will accumulate losses as the put rises in price.

In the video, I will walk through some of the variations on this strategy that you may find helpful as you implement this idea yourself. I will also show you an interesting index you can use to compare the superior performance of a short put strategy to covered calls or a simple long position on the S&P 500 over the long term.


John Jagerson is a contributor to LearningMarkets.com[1]. To learn more about him, read his bio here[7].

 

Endnotes:
  1. LearningMarkets.com: http://www.learningmarkets.com/
  2. writing options: http://www.optionszone.com/learn-more/jim-woods/put-writing-and-call-writing-explained.html
  3. time value: http://www.optionszone.com/learn-more/ken-trester/2008/09/give-yourself-time-to-be-right.html
  4. covered call: http://www.optionszone.com/learn-more/john-jagerson/advantages-of-covered-calls.html
  5. Selling Puts vs. Covered Calls — Which is Better?: http://www.optionszone.com/learn-more/john-jagerson/selling-puts-vs-covered-calls-which-is-better.html
  6. GLD: http://finance.aol.com/quotes/spdr-gold-shares/gld/nys
  7. read his bio here: http://www.optionszone.com/expert-traders/optionszone-experts/john-jagerson.html

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